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Betting against subprime lenders

Steve Tripoli Aug 9, 2007

Betting against subprime lenders

Steve Tripoli Aug 9, 2007


Kai Ryssdal: We continue the subprime story with this thought: Falling markets aren’t the end of the world. Savvy investors have always had a way to make their own silk purses out of a sow’s ear. They bet against companies in trouble, whose share price they think might fall. It’s a practice known as short-selling and it’s not for the faint of heart. If you bet wrong, you can lose more than you have, if that makes any sense. We bring this up today because some people have been shorting the companies that created and financed the subprime debacle. Marketplace’s Steve Tripoli has been asking whether there’s still time for a profitable bet against the architects of subprime.

Steve Tripoli: Rich Gates has been short-selling subprime lenders since late last year. He’s co-manager of the “TFS Market Neutral” mutual fund, and he’s made bets against three lenders that have paid off.

Rich Gates: They’ve been very profitable for us. This has been a segment of the market that’s been absolutely hammered. Many of these securities are down over 50, 70 and even 90 percent for the year.

It’s not just subprime lenders who are targets for short-sellers. Plenty of other companies are caught up in this mess.

Chuck Zender, co-manager of the “Leuthold Grizzly Short Fund,” says it’s easy to identify them by type.

Chuck Zender: Banks, insurance companies, credit companies, mortgage loan companies. The way I like to describe ’em are, companies that deal in pieces of paper.

The problem is it’s hard to value the packages of subprime mortgages these companies hold. That’s because they’re not publicly traded, like stocks. So no one knows what they’re really worth at any moment until they’re actually sold.

Zender: So, in some instances the insiders are saying the last thing they want is these things to trade, because then they’ve got a price to mark ’em to, where without that trade it’s still a theoretical price.

Zender says the big financial firms prefer to mask the extent of their subprime mortgage exposure. They don’t want anyone to know how many bad loans they’re holding, or how they’ve been affected by the subprime debacle.

But that makes it tough for investors to figure out how much these companies, or their distressed securities, are worth. Since they’re flying blind, most will want to bid low.

But that can trigger much bigger problems. Too many low-ball bids can spook the markets. They can feed a downward spiral, which is one way financial panics start.

Zender says we’ve seen it before in the 1997 Asian crisis and the Russian debt crisis that followed.

Zender: That’s exactly what happened is these people bid low, and sometimes the seller doesn’t have any choice, the seller gets forced either by his lender or investors to sell, and then you create these panics in the marketplace when people see, “Oh my gosh, that was the price. What am I gonna do now?”

We’re seeing some of that low-ball bidding in this market. But if you still want to try to make money shorting subprime players you should know you have two strikes against you now.

Venture capitalist Peter Cohan says the first is that it’s late in the game.

Peter Cohan: It is not as good of a time to short as it was back in December. A lot of the bad news was not out in December, but it is out now.

And mutual fund manager Rich Gates says you should remember that shorting individual companies is extremely risky for individual investors.

Gates: So I think the best way for retail investors to participate in short-selling is through a well-diversified portfolio of shorts and maybe through the use of a professional money manager.

Don’t forget, shorting’s about borrowing stocks in the hope of paying them back once those shares tank.

But what if they don’t tank? Borrowing to invest is a form of leverage. If the borrowed stock goes up after you bet against it, your losses can quickly snowball.

That would be ironic. Excessive use of leverage is what got a lot of folks burned by subprime mortgages into so much trouble in the first place.

I’m Steve Tripoli for Marketplace.

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